What is health & welfare plan nondiscrimination testing?
A cafeteria plan and its component benefit plans enjoy favorable tax treatment by the IRS. As a result, the IRS requires these plans to undergo yearly non-discrimination testing. The goal behind the testing is to ensure plans do not discriminate in favor of highly compensated or certain key employees. The Internal Revenue Code outlines specific definitions of who is considered a highly compensated or key employee and these types of employees can be defined differently, depending on the test being performed.
Which plans must be tested?
Plans that must be tested include section 125 cafeteria plans, self-insured health plans, flexible spending accounts (FSA), dependent care FSAs, group term life insurance, self-insured health reimbursement arrangements (HRA), and health savings accounts (HSA). There are 9 different types of nondiscrimination tests; which ones apply to an employer’s plans will depend on the structure of the arrangement and which benefits are available.
What do the tests involve?
The various component benefit plans must pass a series of tests. Some of the tests involve eligibility, which looks at who can participate; benefits and contributions, which considers what benefits are being offered; and utilization, which contemplates who actually uses the benefits and to what extent.
When should nondiscrimination testing be completed?
IRS regulations require nondiscrimination testing to be performed by the last day of the health and welfare plan year. It is recommended that employers conduct a pre-test mid plan year to determine if there are any corrective steps that should be taken, especially when an employer offers different benefits to different employee classes. If a discrimination issue is discovered during the plan year, the employer can make adjustments to the plan to ensure that the plans pass the testing at the end of the year. It is recommended that employers actively contact their non-discrimination testing vendor to determine the testing timeline for the year.
What are the consequences of failing the tests?
Failing non-discrimination testing has negative consequences for all highly compensated and key employees receiving the discriminatory benefits. These employees will lose their ability to receive benefits on a pre-tax basis. Non-highly compensated employees will not be affected. If the discrimination problem is discovered after the plan year has ended, employee salary reductions cannot be re-categorized as post-tax contributions and applicable HCEs or key employees should be taxed accordingly.
The plan will not cease to be a qualified plan if it fails testing, however employers may be subject to additional taxes that were underpaid, as well as any accompanying interest and penalties. The employer would also be responsible for amending any employee W-2s.
Employer Action Items:
- Have non-discrimination testing conducted before the end of the plan year.
For employers on calendar year plans, the end of the year is upon us. Employers need to reach out to their respective vendors to ensure nondiscrimination testing has been completed. It is recommended the employer leave enough time to make any needed plan changes before the end of the year.
- Review the results.
If the test fails, there may be time for the employer to remedy the various plans. It is possible that participant elections may be changed or plan design changes may be made to ensure plans are nondiscriminatory. If a plan fails testing, employers should check in with their testing vendor to ensure all testing strategies have been utilized before making plan changes or taxing benefits.
The information and materials on this blog are provided for informational purposes only and are not intended to constitute legal or tax advice. Information provided in this blog may not reflect the most current legal developments and may vary by jurisdiction. The content on this blog is for general informational purposes only and does not apply to any particular facts or circumstances. The use of this blog does not in any way establish an attorney-client relationship, nor should any such relationship be implied, and the contents do not constitute legal or tax advice. If you require legal or tax advice, please consult with a licensed attorney or tax professional in your jurisdiction. The contributing authors expressly disclaim all liability to any persons or entities with respect to any action or inaction based on the contents of this blog.
